Like chain-retail record stores before it, video game retail’s days are numbered and its demise will come at the hands of the same killer: the Internet. Digital distribution is steadily sweeping away the incumbent channel and delivering it to a clutch of online-based services and retailers like Steam, Amazon, GameFly and Origin. But that club is still absent the true behemoths of the video game industry in Microsoft, Sony and Nintendo. That may be about to change, whether anyone wants it to or not.

“We’re already seeing the beginning of that with some of the recent sales numbers that are out there,” says Julien Lavoie, director of public relations for the Entertainment Software Association of Canada. Data from ESAC show that as of February 2011, digital distribution accounted for 6% of sales by revenue—but 35% of sales by unit. In the much larger U.S. market, digital distribution accounts for 24% of sales, up from 20% in 2009. (NPD does not release unit sales figures for the U.S. market.)

The first parties (console manufacturers, also known as OEMs) and third parties (publishers) are starting to recognize what the PC industry has known for years. Namely, that savings from the elimination of physical retail—cost of goods sold inputs like shipping, packaging, wholesaling, returns, bad debt allowances, retail display and in-store marketing—gets added to the operating margin. Revenue can be further increased by monetizing consumers via in-game transactions and, without the need for what is limited shelf space, product life-cycles are indefinite (the “long tail”). The shift has radically changed some business models and destroyed others outright. But that’s on PC.

In fact, console makers Microsoft, Nintendo and Sony face a similar challenge from the growth of the digital channel. Depending on who you talk to, they’re either well-placed to take advantage of it, or about to go the way of Tower Records. Right now, they occupy a delicate middle position where the promise and benefits of digital distribution are in sight, but their existing dependence on retail obliges them to focus resources on what appears to be an increasingly outmoded channel.

Led by Valve Corporation’s Steam service, a sort of walled distribution platform offering games as well as community features, the PC market went digital almost a decade ago. But that market is a fraction of the size of its console brethren; migrating the console market to digital distribution represents the next Holy Grail of industry revolution.

According to NPD Group the size of the retail PC software market in the U.S. in 2010 was about US$700 million, far smaller than that of consoles at US$9.4 billion. (Another US$5.8 billion is attributable to social gaming, digital add-on content, subscriptions and the like, some of which is its own category and some of which would go either to PCs or consoles.) And according to DFC Intelligence, in 2011 the size of the digital PC software market was about US$2.4 billion, but for consoles only US$1.6 billion.

This suggests there is significant room for growth of the console market’s digital channel—and the profitability of the associated console makers and publishers (console makers are also often the publisher as well).

“The reality is that digital is the best solution,” says Jason Della Rocca, founder of Montreal-based consultancy Perimeter Partners. “Cost of goods go down, you’re cutting out the middle man, you enable long-tail discoverability, virality, all this kind of stuff.”

While none of the console makers would divulge specific numbers, according to a variety of industry players and observers, the savings a first party or third-party publisher can see in moving from physical to digital distribution range between 10%-30% of gross margin. And this doesn’t take into account long-tail sales, and sales that would otherwise have been lost either to piracy or the multi-billion-dollar used game market.

Stephen Turvey, VP and GM of Sony Computer Entertainment Canada, declined to reveal the specific savings, but says, “There is a savings. You’re saving the physical cost of producing and shipping those goods [and the in-store marketing].”

As former co-founder of Ubisoft Montreal and founder of EA Montreal, both publishers, Alain Tascan has direct experience in the industry. Now solo as president of social media games publisher Sava Transmedia, he says income statements he’s seen indicate about a 30% increase in gross margin, although he cautions that advertising and customer acquisition costs (e.g. discounts, incentives, etc.) can still bring that down to something closer to parity with physical distribution.

Lewis Ward, a research manager at IDC, says the typical breakdown on the price at physical retail is that the first party and publisher (sometimes these are the same entities) gets 55% of retail, the retailer gets 30% and another 15% goes to cost of goods, royalties, returns and distribution. This changes dramatically as you move toward the Nirvana of digital distribution for the first parties—selling digitally through their own network. With the e-tailer cut out the first party/publisher share rises as high as 90%, good for a gross margin of about 75%, up from 45% at physical retail. (Note that these figures can vary widely from game to game and publisher to publisher because different deals are struck for each.) This is what the console makers could potentially expect if they were to sell full, premium games direct through their networks like Xbox Live or the PlayStation Network. (In fact, they already do this, but most with a minimum six month delay, which effectively hands the business to retail.)

Says Piers Harding-Rolls, head of games at U.K.-based IHS Screen Digest, in an e-mail, “I expect to see increasing downloads over this generation and on to the next generation of devices as it is in the interest of console manufacturers to act as a retailer.”

In a sign that the shift is already underway, the industry’s highest profile retailer yet, the U.K.’s Game Group PLC, which had 1,300 stores across Europe and Australia, filed for bankruptcy in March and has since had its much reduced U.K. operations scooped up by a private equity firm. In addition to the punishing effects of recession, the company’s decline was said to be due in part to consumers increasingly purchasing and downloading online. In the U.S., retailer GameStop is being proactive, having recently begun offering PC downloads; it’s now ramping up its offering of codes for digital access to console game add-ons and purchased Spawn Labs in March 2011, which boasts a technology that is supposed to allow streaming of console games. Publishing giant EA has successfully launched its Origin platform to distribute its own and other publishers’ PC games, laying an infrastructure that at least in theory should also be able to support delivery for consoles.

But the console makers and third party publishers sound a lot like career politicians when they talk about walking the line between the old and new worlds. They say their partnerships with retail remain strong and they envision working with retail into the foreseeable future.

“I think as much as we’re saving [via digital distribution], at this stage you would lose a lot more than you’re saving by not having a retail solution as well,” says Sony’s Turvey.

He admits retail has been vocal about protecting its multi-billion-dollar turf. “It’s made up a large part of our conversations with retail and in our partnerships,” he says. “Sure it’s about today, but it’s also about looking ahead and those relationships and partnerships will continue to grow, but they will change. I think you’ll see retail take a very active interest in providing digital content. Whether it’s through their brick and mortar outlets or on their own sites, they’re certainly looking for ways to participate and we’re looking for ways for them to participate.”

Over at Microsoft, Glenn Purkis, product manager for Xbox Live Canada, points to the Games on Demand service for the Xbox 360, which he says now offers over 300 premium games for download. He describes the US$73 billion company as “committed to digital distribution.” But in the next moment he says, “Retail is critical in the whole ecosystem and ultimately that is where our members will purchase a console, and first releases and the accessories for the Xbox 360. So our commitment to retail is our No. 1 priority.”

Asked if the industry’s goal is to go all digital, EA’s David DeMartini, SVP Origin, laughs and is only slightly more forthcoming. “Well, that’s sure my goal! I think we should have as broad a distribution on every platform as is feasibly possible. And clearly games can be distributed via Xbox Live, via PSN (PlayStation Network), and I think they absolutely should. But I certainly don’t control what Microsoft does or what Sony does. Over time the console side is just on a slightly slower continuum than the PC side is.”

The problem is, the Microsofts and Sonys of this world may be running out of time. Gene Hoffman is the CEO of Vindicia, a company that provides billing services for a range of businesses, including publishers like Blizzard, for the latter’s multi-million selling sensation World of Warcraft. He’s also the founder of E-music, which was sold to Universal in 2001. When he spoke at the Consumer Electronics Show (CES) in January, he was blunt about the prospects for physical retail and he remains as candid a couple of months later. “The interesting question is I’ve lived this story before. At E-music. Every single major music company tried to tell everybody that the major retailer is going to be the way that they reach the consumer. And of course that was 24 months before Tower Records went bankrupt.

“From a console perspective it’s not clear to me that there’s not one more cycle, but even there you’re starting to see the console become extremely Internet aware and in fact thinking of itself as an app store. So exactly which channel are we talking about? Well, I understand the channel conflict—I’ve seen it and lived it before. But at the end of the day the consumer prefers to not necessarily have to go to the store. Your average game store doesn’t really add a ton of value, per se, to the average gamer.”

But as is often the case with politics—and business—better to watch what they do rather than what they say: Nintendo Canada GM and VP Ron Bertram told Canadian Business Online that the company was uninterested in gaming experiences that required the player to go online and buy additional content to complete a game. But in January, Nintendo announced the Nintendo Network, the purpose of which is to digitally distribute full retail games. President Satoru Iwata further described it as establishing “a platform where various services available through the network for our consumers shall be connected via Nintendo Network service so that the company can make comprehensive proposals to consumers.”

And at press time, as reported by industry publication MCV, Sony announced plans to acquire an unnamed cloud gaming provider thought to be Aliso, Viejo-Calif.-based Gaikai. Again, the purpose here would be to stream console games to consumers directly over broadband.

Digital distribution enables what Marc Jackson, founder and CEO of interactive entertainment-focused VC Seahorn Capital Group, calls the ‘disintermediation’ of the industry; and it affects too many partners at once for the first parties to jump in as quickly as one might expect, despite the potential profit upside. With the exception of Nintendo, which makes most of its own games, the retail-based model sees the first parties make most of their money via licensing the right to third party publishers and developers to make games on their platforms. But moving to digital distribution would not only cut out the retailers but could also lead developers—the companies that create the content—to go straight to the first parties and leave out the third party publishers, like the relationship that exists between them and Apple. That’s a lot of unhappy businesses that have invested tens of billions of dollars into an existing ecosystem. “Right now because they have all of these partners internationally, especially very big Japanese publishers, very big European and U.S. publishers that are third party that are reliant on this ecosystem,” explains Jackson. “And if all of a sudden first parties pull the plug, it’s not clear how that would shake out.”

However, it’s not just channel conflict; there are also technical, marketing and even cultural hurdles to be overcome.

For instance, while hard drive sizes on the consoles are of decent size, they’re not yet the hundreds of GBs one sees commonplace in PC computing, so there is a storage issue. “There’s so many technical hurdles,” says Nintendo’s Bertram. “And gamers now are from 6 years old to 75 so I think [digital distribution will] become a popular way but I certainly don’t think it’ll become the exclusive way. … One of the number one reasons is just the size of the games. And you have to be cognizant of a customer’s SD (secure digital) card size and all those kind of things.”

Although perhaps understating the speed of even budget broadband, Sony’s Turvey isn’t completely incorrect when he points out that Internet databases would have problems handling significant amounts of very large simultaneous downloads. “The games on a double-sided BR disc would take the better part of a couple of days to download in some of those AAA [the video game equivalent of a Hollywood blockbuster] cases,” he says.

And as the recent, technically troubled launch of publisher/developer Blizzard’s record-selling Diablo III for PC suggests, it isn’t clear that the industry has the database and server muscle to handle multiple AAA games (such as Call of Duty) being sold digitally for the much larger console market.

Sony has another relevant experience worth noting. Back in April 2011—square in the middle of launches for big titles like Mortal Kombat—its PlayStation Network was hit by a major hacking attack. At first the shutdown was to last only a few days, but a few days stretched into an unprecedented six weeks at a cost to the company of approximately US$171 million. Ouch. What that might do if Sony’s retail was mostly or completely dependent on digital is anyone’s guess, but “ruinous” comes to mind. No doubt, this experience has to give Sony and its competitors some pause.

The hype value of the launch-day (or night, as these things usually go) retail store release also can’t be dismissed. Night clubs purposely keep people waiting outside, the intent being that the lineups help create the impression among passersby that this is a place they need to be. The same cultural psychology applies to the marketing of video game (or any highly sought after tech product) releases, which are often accompanied by on-site publicity events picked up by the media.

David Cole, lead analyst at DFC Intelligence, says, “Having that retail presence is still a very important part of driving consumers to the product, and really getting them to rush out to the store to get the latest title as it comes out, that’s almost become like an event. And also that point-of-sales marketing of having a display where you can get that impulse purchase is still very much an important part of things overall.”

It’s going to take some time for buyers and sellers to work through their myriad issues. What the console industry doesn’t want to have happen though is to be taken by surprise, where customers get ahead of the curve and hand their business over to other players almost entirely, as happened with the music industry and the rise of Apple. There are already glimmers of that in the explosive growth of social media and mobile gaming, where the console makers as yet have no answer and only a minimal presence (some AAA games, such as Dead Space and Call of Duty, have mobile versions, but critical reception has been mixed).

It could be worse. Jackson isn’t convinced the console makers themselves are necessarily long for this world. Right now these first parties maintain their industry dominance by funneling the game experience through “locked” consoles that are essentially custom PCs. But Jackson argues a shift is underway because next generation technology is allowing near-console quality gaming to be done via chips on devices as small as a smartphone or tablet; coupled with digital distribution via cloud or streaming, it calls into question the need for a console in the first place. So if the first parties “disintermediate” by going all digital they could, ironically, obsolete themselves.

Clues as to how this might happen lie in nothing more innocuous than your TV. While Microsoft and Sony trip over themselves trying to position their consoles not merely as consoles but as “entertainment centres” (movies, music, games, etc.), modern TVs are to a large extent already doing this natively through telecom companies. A typical LG, Samsung or Sony TV comes with access to everything from Netflix and music, to apps and simple games. What’s to say the computing power that’s already in a tablet—or console—can’t simply come stock with your TV? What do you need this separate box for?

Asked if Sony has given this potential challenge any thought, Turvey says, “I’d be concerned if we haven’t thought about it, and there’s a lot smarter people than myself—our engineers in Tokyo—that have solutions for all these opportunities. But if I look back when I joined Sega, which was leading the industry at the time with its Genesis machine, there was this grand vision of there only being one box that would exist and it would control your movies and your game content, and it’s 20+ years later and I think we’re there now or pretty close.

“I don’t even know if we’re there with the one-box solution. So to speculate further than that, do I think that exists? Absolutely. You’d be silly not to. But how that exists I don’t know. Whether the box exists within your panel, there’s different ways that might look versus considering that the box might disappear entirely. Maybe the box is just well hidden.”

While Jackson’s musings are provocative, it’s a safe bet the console makers have a minimum of one generation left to do business more or less as usual, although hardware improvements designed to take advantage of streaming and cloud computing seem almost certain. But given the increasingly competitive landscape—especially from mobile and social gaming, but also from software-as-a-service and streaming solutions like Gaikai, OnLive and GameStop’s Spawn Labs—they need to maximize their revenue as quickly and efficiently as possible. As Microsoft stated in its 2011 annual report concerning its Entertainment and Devices division, “The markets for our products are characterized by significant price competition, and we anticipate continued pricing pressure from our competitors.”

If you look at revenue for Sony and Microsoft, both explicitly point to their gaming divisions as buoying numbers in what are otherwise generally tough times. Microsoft attributes the company’s overall 12% revenue growth for fiscal 2011 primarily to “strong sales” of the Xbox 360 and some other key products like its Servers and Tools products. Its Entertainment and Devices division, which houses all its gaming business and consumer phones, took a big hit last quarter, but operating income more than doubled from 2010 to 2011, to US$1.3 billion on revenues of US$8.9 billion.

Sony, which recently posted its biggest loss in history, points to one bright spot in its portfolio of businesses, its Networked Products and Services division. NPS includes the gaming business, which, at US$9.2 billion, accounts for more than half of the division’s revenue. NPS swung from an operating income loss in 2010 of US$1 billion to a gain in 2011 of US$450 million, a 233% turnaround. What’s remarkable is that this was on a sales increase of just 0.4%. (The significance of Kazuo Hirai, who headed the gaming division, being appointed president to lead a turnaround, shouldn’t be lost on observers either.) According to its 2011 annual report and sources at Sony, higher software sales and a reduction in the cost of sales attributable to production of the PlayStation 3 console contributed to the improved performance. This suggests how much of a difference cost of sales can make to profitability and, as the PC games industry has already showed, digital distribution plays a key role.

Equities analysts don’t doubt that’s the case, but point out that for such large, diversified companies, the gaming business remains a junior part of their operations (although they’re huge by any stand-alone measure).

“That’s just the nature of the beast with Microsoft and the Windows [division],” says Josh Olson, analyst with Edward Jones. And ultimately with Windows 8 approaching, that’s really going to be what carries the day for Microsoft for awhile. However, I do think they need to improve the cost of goods sold. They can’t let this just continue to weigh on their profitability.”

Olson says the end-game for Microsoft is to move toward a subscription-based pricing model—and that means going digital. “That helps not only with lowering costs, but also with helping with piracy and a number of other things. That’s an initiative that is overarching in terms of not just in entertainment, but across all their divisions. So something to keep an eye on is more subscription based, cloud-based, software-as-a-service type model in this category.”

Here again, the PC games industry—perhaps emblematic of its more pressing struggle to survive over the last decade—has led the way with new business models, or marketing strategies as some prefer to call it. Spearheaded by highly successful games like Riot Games’ League of Legends, PC gaming has moved aggressively toward the free-to-play and in-session transaction model, which allows for downloadable content in the form of micro-transactions. These have the potential to significantly increase revenue-per-player, and are inherently dependent on digital distribution as the access method.

As Jerry Brown, associate partner in PricewaterhouseCooper’s consulting practice, recalls, “I saw a presentation given by one of the major studios where they pointed out that when they sold a [game] for a console they expected to collect $50 per consumer and that was it. By moving to a [free-to-play] micro-transaction model, they allow the consumer, as they nicely put it, to spend more with them, such that the average revenue per subscriber had gone up to between $60 and $70. They certainly had some people who were on the free-to-play part who were only spending $10 or $12, but others were spending $50 to $100. The really key point was the average per consumer was higher and had a longer tail.”

Seahorn’s Marc Jackson insists this is where the console industry has to go as well, and it’s only possible now that software can be reliably delivered as a service. “They’re looking to change the whole model,” he says. The only question left to ask may be, how soon is now?